Wednesday, 29 April 2009

Economic illiteracy

ANZ Bank revealed today it set aside $1.4 billion for bad loans in the half year to March. It follows National Australia Bank's $1.8 billion bad debt charge flagged in its half-year results yesterday.

''We should be a bit nervous because we haven't seen the worst of it yet,'' said Nicole Rich, of the Consumer Action Law Centre, advocacy group. The rising bad loans and provisions were worrying given that both interest rates and petrol prices have fallen in the past half year, she said.

''Essentially, the provisions are not for people who default on their mortgages per se, it's for when they default on their mortgages but don't have enough equity in the property to cover the bank's losses,'' she said.

''Banks and lenders have obligation under the Consumer Credit Code.''

I think Nicole Rich should bone up on what a provision for bad debts by banks actually is, particularly when it comes to housing loans.

Here is my definition of what a bank would be providing for.

Mr & Mrs Bogan borrow $530,000 to buy a $500,000 house in 2004. The extra $30,000 is used to cover fees and charges associated with buying the house.

By 2009, they have paid off $30,000 of the loan, but the housing market has softened and their house is now only worth $400,000. They still owe the bank $500,000. The bank auctions the house, pays the costs associated with the sale and books a loss of $100,000 on the deal - that is the bad debt. A provision for bad debts is when you know you are faced with lots of these, and you set funds aside to cater for them.

It has nothing to do with how much equity the owners have in the property. The only two factors that count in these circumstances are the remaining portion of the loan and the market price of the property. If the bank is preparing to write money off, it means the owners already have zero equity in the home. They are in fact in negative equity.

Nicole Rich would have been better of saying that these people borrowed more money than they could afford and paid too much for their homes. As a result, lawyers are running around blaming banks.